Baking on the future the fall and rise of central banking davies and green

Banking on the Future


This page intentionally left blank


Banking on the Future
THE FALL AND RISE OF CENTRAL BANKING

Howard Davies
David Green

princeton university press
princeton and oxford


Copyright © 2010 by Princeton University Press
Published by Princeton University Press,
41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press,
6 Oxford Street, Woodstock, Oxfordshire OX20 1TW
All Rights Reserved
Library of Congress Cataloging-in-Publication Data
Davies, H. (Howard), 1951–
Banking on the future : the fall and rise of central banking /
Howard Davies, David Green.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-691-13864-0 (alk. paper)
1. Banks and banking, Central. 2. Monetary policy. I. Green,

David, 1946– II. Title.
HG1811.D38 2010
332.1’1–dc22

2009053367

A catalogue record for this book is available from the British Library
This book has been composed in Lucida using TEX
Typeset and copyedited by T&T Productions Ltd, London
Printed on acid-free paper

∞

press.princeton.edu
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1


Contents

Preface

vii

Abbreviations

ix

Introduction

1

Chapter One
What Is Central Banking and Why Is It Important?

9

Chapter Two
Monetary Stability

23

Chapter Three
Financial Stability

52

Chapter Four
Financial Infrastructure

90

Chapter Five
Asset Prices

115

Chapter Six
Structure, Status, and Accountability

141

Chapter Seven
Europe: A Special Case

182

Chapter Eight
Central Banking in Emerging Market Countries

212
v


CONTENTS

Chapter Nine
Financial Resources, Costs, and Efficiency

236

Chapter Ten
International Cooperation

252

Chapter Eleven
Leadership

270

Chapter Twelve
An Agenda for Change

285

Afterword

297

Notes

301

Index

317

vi


Preface

We were prompted to write this book by the realization during the winter of 2007–8 that major shifts were suddenly afoot in the world of central banking. After an extended period in which central banks appeared
to be capable of doing no wrong, the objectives, and even the roles, of
central bankers were being abruptly questioned, as were the tools they
had at their disposal and the way they used them. What really was the
purpose of a central bank? Had central banks somehow lost their way
and forgotten what they were there for? Were long-dormant functions
being rediscovered? As we continued to write during 2008 and 2009,

such questions became more and more acute.
This is not an academic textbook about the economics of monetary
policy, nor is it a detailed historical account of the evolution of the role
of the central bank. Still less is it a technical guide to the nuts and bolts
of central bank operations and activities.
Rather, it seeks to set recent events in the context of the wider
perspective—asking what central banks are for, why their role is critical
to the functioning of market economies, how they can best go about fulfilling that role, and whether recent experience and historic perspective
point to the need for further reappraisal and reform. We particularly look
at the wider political and institutional framework in which they operate.
In setting the wider scene in which the crisis unfolded, we became
conscious that the recent and unprecedented wholesale disruption that
struck the financial system was in fact foreseen, or at least foreshadowed, by some serious observers, both within central banks themselves
and in academia. It is disappointing to note that much of this thinking,
whether on asset price bubbles or the procyclicality of capital requirements under the second revision of the Basel capital accord, was largely
ignored by practitioners at the time. We hope that this volume, which
integrates a review of academic writing with the perspective of current
central bankers, will help bridge that important gap.
vii


PREFACE

We also draw on our own direct experiences, whether during the time
when we were practicing central bankers ourselves or when we were
working alongside the central bank in a separate financial regulatory
organization. Inevitably, what we write is colored by that experience.
We would particularly like to thank our former central banking colleagues, Clive Briault, Alastair Clark, Andrew Crockett, Michael Foot,
Charles Goodhart, Lionel Price, David Strachan, Philip Turner, Geoffrey
Wood, and Paul Wright, each of whom reviewed earlier drafts in full or

in part and frequently contributed fresh insights. Staff at the Bank for
International Settlements were especially helpful and gave us access to
their work. We are grateful to Rosa Lastra for a number of detailed suggestions as well as for the wealth of fundamental material to be found
in her own writings. We are also indebted to the many central bank governors and other senior officials, past and present, to whom we talked
as we assembled our own thoughts. They were generous with their time,
even during what was a fraught period.
At the London School of Economics Nick Vivyan was an invaluable
guide to the academic literature. Clare Taylor Gold, Rachel Gibson, EmilyJane McDonald, and Sally Goiricelaya all worked hard to ensure that a
final text saw the light of day. Richard Baggaley at Princeton University
Press was encouraging throughout and we are grateful to Sam Clark of
T&T Productions Ltd, our copy editor, who pressed us tirelessly to ensure
that our sentences really worked and our references too. Susannah Haan
also provided helpful comments.
Lastly, we need to note that the views expressed here are entirely our
own and not those of any of the organizations with which we are or have
been associated.
The final revisions to this manuscript were undertaken in August 2009
and the reader will need to bear this in mind in the ever-evolving world
of central banking.

viii


Abbreviations

AIG
BCCI
BIS
CGFS
CHAPS

CPI
CPSS
CSRC
DMO
ECB
EMC
EMU
ERM
ESCB
ESRC
EU
FOMC
FSA
FSB
FSF
FSI
FSR
IFI
IMF
IOSCO
IT
Libor
LOLR
MENA
MOU

American International Group
Bank of Credit and Commerce International
Bank for International Settlements
Committee on the Global Financial System

Clearing House Automated Payment System
Consumer Price Index
Committee on Payment and Settlement Systems
China Securities Regulatory Commission
Debt Management Office
European Central Bank
Emerging Market Country
Economic and Monetary Union
Exchange Rate Mechanism
European System of Central Banks
European Systemic Risk Council
European Union
Federal Open Market Committee
Financial Services Authority
Financial Stability Board
Financial Stability Forum
Financial Soundness Indicator
Financial Stability Review
International Financial Institution
International Monetary Fund
International Organization of Securities Commissions
Inflation Targeting
London Interbank Offered Rate
Lender of Last Resort
Middle East and North Africa
Memorandum of Understanding
ix


ABBREVIATIONS

MPC
NCB
NPLs
OECD
PBOC
RBA
RBI
RPI
RPIX
SDR
SEC
SGP
T2S
UAE
WTO

x

Monetary Policy Committee
National Central Bank
Nonperforming Loans
Organisation for Economic Co-operation and Development
People’s Bank of China
Reserve Bank of Australia
Reserve Bank of India
Retail Price Index
Retail Price Inflation (excluding housing)
Special Drawing Right
Securities and Exchange Commission (U.S.)

Stability and Growth Pact (EU)
Target 2 Securities
United Arab Emirates
World Trade Organization


Banking on the Future


This page intentionally left blank


Introduction

The global credit crisis that began in the summer of 2007 threw a large
rock into the calm waters of central banking. Though many commentators, and indeed some central bankers themselves, had for some time
been drawing attention to the risks posed for financial stability by global
imbalances, surging credit, and liquidity, and narrowing risk spreads,
when the crisis hit in August 2007 the speed and severity came as a
surprise, not least to central bankers.
The proximate causes of the crisis lay in securitizations based on the
subprime mortgage market in the United States, but the first serious
signs of a major liquidity problem in the banking system were observed
in Europe. On 9 August BNP Paribas froze three funds it managed, blaming “a complete evaporation of liquidity in certain market segments of
the U.S. securitisation market.” On the same day the ECB launched emergency operations to boost liquidity and injected almost €100 billion into
the market, in an attempt to bring down overnight lending rates. The
operation was successful, up to a point, but did not prevent the subsequent collapse of IKB in Germany, the first of several European bank
failures.
In London, the first major casualty was Northern Rock, a mortgage
bank heavily reliant on short-term wholesale funding. The Bank of England initially declined to provide emergency liquidity support to facilitate the sale of the bank to another, larger institution. Lloyds TSB (as

it then was) was reported to be ready to take on the bank on condition that the Bank guaranteed funding for a period. But the Bank did
eventually provide upward of £30 billion in funding, the disclosure of
which led to the first bank run in the United Kingdom for over 150 years
and eventually, after an undignified attempt by the government to sell
it to Richard Branson, the airline entrepreneur, to the nationalization of
Northern Rock.
In the United States, the Federal Reserve cut rates sharply, expanded
its own liquidity operations, and broadened the range of collateral it
1


INTRODUCTION

was prepared to accept. In spite of these efforts, by March of 2008 the
Federal Reserve Bank of New York was obliged to engineer a rescue of
Bear Stearns through a heavily discounted sale to J.P. Morgan, and furthermore to open the discount window to the investment banks, a move
which it had long resisted.
Through the summer of 2008 more and more institutions came under
pressure. In Benelux, Fortis failed. In the United Kingdom, Alliance &
Leicester was rescued by Santander, while Bradford & Bingley was dismembered, leaving the government holding the mortgage book. In the
United States, other banks emerged as needing public support, notably
Washington Mutual, Wachovia, and Indymac. Then, in mid September,
the crisis entered a new and more dramatic phase. The insurance group
AIG was expensively rescued, but in the same week Lehman Brothers was
allowed to go to the wall, precipitating generalized panic across global
financial markets. The U.K. and U.S. governments, followed by others,
took direct stakes in systemically significant institutions, including the
major investment banks, which changed status to become bank holding companies with Federal Reserve support. By the spring of 2009 the
British government owned majority stakes in both the Royal Bank of
Scotland and a new entity created by the merger of Lloyds TSB and Halifax Bank of Scotland. Monetary policy was further relaxed over the winter of 2008–9, with interest rates approaching zero in many developed

countries. Once zero, or close to it, had been reached, further reductions
in the policy rate were no longer an option and central banks resorted
to “quantitative” (or “credit”) easing: buying commercial or government
securities directly, increasing the supply of base money.
As the crisis rolled on, leaving wreckage in its wake in the financial
markets and pushing Western economies into recession, questions were
inevitably asked about who was responsible for the debacle. The major
financial institutions themselves were, of course, the prime suspects. It
was argued that their incentive structures had led them to take excessive risks, and that their boards and senior management did not understand the characteristics of the complex instruments to which they were
increasingly exposed. The whole credit risk transfer business, ostensibly designed to allow risks to be held by those best able to bear them,
appeared to have, instead, left risks with those least able to understand them. There seemed to have been a dislocation between the financial and the real economies, with the nominal values of the derivative
instruments, in which the losses were concentrated, parting company
from the value of the underlying assets. In these markets business had
2


INTRODUCTION

been increasingly concentrated on creating large risk exposures purely
between financial firms, rather than between them and their customers.
By 2007 the nominal value of the credit default swap market was over
$40 trillion. It was argued that the “originate to distribute model” was
fundamentally broken, and that hedge funds—always available to play
the role of stage villain—had acted as destabilizing players. They were
widely accused of engineering the collapse of Bear Stearns, for example.
Ratings agencies had connived in the fast expansion of the market,
earning fees for rating each new securitization. Some ostensibly AAArated securities traded at a fraction of their face values. The credibility
of the agencies was severely damaged, and many critics pointed to fundamental conflicts of interest at the heart of the agencies’ business models.
Monoline insurers, whose backing had allowed securitizations to achieve
AAA status, collapsed into the arms of the public authorities.

Regulators were also seen as part of the problem: too slow-moving
to understand what was happening on their watch and powerless, or
even unwilling, to control it. Prudential regulators, whether in central
banks or outside them, had overseen banking systems that were undercapitalized when the crisis struck. The capital requirements imposed on
banks proved in many cases to be wholly inadequate to absorb the losses
incurred, and perhaps, through magnifying procyclical effects, added
fuel to the flames of the asset price bubble that preceded the crash.
Backward-looking capital requirements tended to fall as asset prices
rose. The absence of effective oversight of the creation of credit through
the derivative markets was argued to be a further weakness. Regulatory
arbitrage had created a shadow banking system, and a proliferation of
off-balance-sheet “structured investment vehicles,” which regulators had
largely ignored. A comprehensive global overhaul of the practices and
structures of financial regulation was launched, with parallel reviews in
the United States, the EU, and many individual countries.
Politicians, too, were in the firing line, especially in the United States,
where pressure on the government-sponsored enterprises Fannie Mae
and Freddie Mac to support lending to poorer families was a powerful
impulse behind the expansion of the subprime mortgage market. Even
private citizens could not escape blame. The collapse of personal savings, especially in English-speaking countries (though the Spaniards have
acquired honorary Anglo-Saxon status in this context), and the associated credit-fueled consumption and house price bubbles were factors
underlying the boom and subsequent bust.
3


INTRODUCTION

It was not long before the role of the central banks themselves began to
be seriously questioned. How could they have allowed such huge financial imbalances to build up without reacting? Were they, too, asleep at
the wheel? Or, as one central banker himself put it, how was it that the

radar was not connected to the missile defenses? In retrospect it is easy
to see that risk spreads had reached unsustainably low levels and that an
explosion of liquidity and credit had fueled dramatic asset price appreciation, especially in the property markets. Consumption growth was
further stimulated by the “release” of equity from property. Yet through
this period central banks, and especially the Federal Reserve, had maintained low interest rates, focusing attention narrowly on the behavior of
consumer prices.
Steve Roach, the former chief economist of Morgan Stanley, argued
that the central banks themselves bore the prime responsibility for the
crisis.1 “Central banks,” he said, “have failed to provide a stable underpinning to world financial markets and to an increasingly asset dependent global economy . . . the current financial crisis is a wake up call for
modern day central banking . . . the art and science of central banking is in
desperate need of a major overhaul—before it’s too late.” John Taylor,2
author of a celebrated rule for monetary policy making, similarly placed
most of the blame on monetary policymakers: “there is an interaction
between the monetary excesses and the risk-taking excesses.”
Less outspoken critics advanced similar arguments. Was there not a
fundamental problem with the way central banks’ objectives had been
specified, with a narrow focus on consumer prices? Even if it may be
unrealistic to expect central banks to prevent all financial bubbles and
head off all prospective crises, they could nonetheless “lean against the
wind” of emerging imbalances and bubbles. Economists at the Bank for
International Settlements, the central banks’ own central bank, had been
arguing as much for some years. In an important paper published in January 2006, Bill White, then chief economist of the BIS, maintained that,
while central banks had been successful in the recent past in delivering
low variability of both consumer price inflation and output, numerous
financial and other imbalances had emerged and, should these imbalances revert to the mean, there could in future be significant effects
on output growth. He asked whether monetary and regulatory policies
should give more attention to avoiding the emergence of imbalances in
the first place. Others argued that the central banks had in fact been
misled by low reported consumer price inflation, which had been artificially held down by the emergence of China and India on the global
4

INTRODUCTION

scene, and the arrival in world markets of hundreds of millions of new
workers prepared to work at very low rates of pay. The increased savings
propensities of Asian economies meant that strong demand growth in
the United States was not inflationary.
Former Federal Reserve chairman Alan Greenspan’s initial response to
this critique was robust. In his view central bankers could not hope to
head off asset price bubbles and should not attempt to do so. The most
a central bank could do was to mop up efficiently after the event. While
the markets continued to power ahead, and confidence in the maestro’s
ability to keep the music playing remained high, the Greenspan view
dominated. But as the scale of the crisis became apparent, more critics
emerged. Greenspan himself offered a partial recantation of his earlier
view, and by 2009 his reputation had taken a dive.
Other charges were brought as well. Had the central banks failed to
keep up with changes in financial markets and grown too distant from
them? Sir John Gieve, then the deputy governor of the Bank of England,
admitted that “we hadn’t kept pace with the extent of globalization.”3 He
maintained, too, that the Bank had not had the tools needed to respond
to an asset price bubble. That reinforced the argument of those who
believed that governments had been wrong to separate central banks
from banking supervision.
Neither the European Central Bank nor the Bank of England were themselves direct supervisors of banks. In Japan, too, the Japan Financial Services Agency has the prime responsibility for banking supervision while
the Bank of Japan is supposed to oversee only bank liquidity. In the
United States, the Federal Reserve has only partial oversight of the banking system and had no direct supervisory relationship with the investment banks at the eye of the storm. Had this partial perspective been a
handicap, preventing them from building a full understanding of what
was happening to credit? Much of the credit expansion that fueled the

boom had taken place outside the regulated banking system.
Furthermore, while central banks everywhere were thought to have a
responsibility for something called financial stability, the nature of that
responsibility was rarely spelled out, and the tools with which they might
promote it were ill-defined, perhaps nonexistent. A large financial stability industry sprang up from the mid 1990s on, producing reviews at a
great rate, but it had little measurable impact on policy or on markets.
Just as Roach had argued was the case in the monetary arena, was there
not a need for a fundamental rethink of the appropriate role of central
banks in today’s more diverse and global financial markets? In particular,
5


INTRODUCTION

the links between monetary and financial stability looked in need of serious attention, as indeed did the relationship between the real economy
and the financial system.
Questions were asked, too, about the effectiveness of coordination
between central banks as the crisis hit. Central bankers had long prided
themselves on their habits of communication and cooperation with each
other. They meet privately every two months at the BIS headquarters
in Basel, where, we are told, they talk frankly and openly about monetary and financial developments. These habits of cooperation are far
better developed than those between finance ministries, or among other
kinds of regulators. But in the summer of 2007 the benefits of this network were not very visible and, despite intensive discussions behind the
scenes, it was not until December that the first public signs of a coordinated approach to the provision of liquidity were seen. Even then, it
became painfully clear that the techniques they used to assist the market
were clumsy and out-of-date. The monetary authorities proved unable to
establish the structure of interest rates that they wanted to see, and their
money market intervention techniques needed almost constant reengineering.
There was worse to come. Even those who maintained stoutly that
the central banks could not be blamed for the genesis of the crisis, and

who supported the Greenspan line on crisis resolution, were alarmed
to discover that they were ineffective even at the crisis resolution task.
Interest rate cuts, even on an unprecedented scale, proved to be inadequate, and even massive injections of liquidity on terms that the central
banks would not have considered feasible beforehand failed to rebuild
confidence for a long time. During the Greenspan era financial markets
had come to believe in the myth of the all-powerful Federal Reserve. It
was seen to have feet of clay when the crisis hit.
Perhaps the high water mark of central bank power and influence had
been reached. Was the golden age of central banks, a period in which
their independence and autonomy had been widely accepted around the
world, now over?
What Mervyn King had called the NICE decade—noninflationary and
consistently expansionary—came to an end with a crash. Mervyn King
himself had come into office claiming the ambition to make monetary
policy “boring.” By that he meant that interest rate decisions should be
as predictable as possible, with deft touches on the tiller from time to
time in order to keep inflation within the target range. For a time, he
came close to succeeding, but from the middle of 2007 onward central
6


INTRODUCTION

banking certainly became “interesting” again, in the sense of the overworked Chinese curse. In late 2008 the Bank slashed rates by 100 basis
points, then by another 150, in short order, which many saw as recognition that it had fallen behind the curve.
But, while it was accepted that some kind of overhaul of practice and
procedure was required, there was no easy consensus on what such an
overhaul might entail. Was there a need for more coordination of central bank policies with those of other authorities? Should central banks
become less powerful and be made more subject to political control,
or be given more tools to achieve financial stability? Had the trend of

removing central banks from direct supervisory responsibilities gone
too far? Should that trend, indeed, be reversed? Did the crisis reveal a
need for different types of expertise within central banks—particularly
more market-related skills?
In this book we explore these arguments and offer answers to these
and other questions. We argue that a new approach to central banking
is indeed required in response to the crisis, and sketch out what we see
as its key features. In part, this involves central banks returning to their
roots in financial markets: forward to the past, perhaps.
To answer the questions, we need, first, to explore the ways in which
central banks have evolved in the last two decades, in both developed
and developing economies. So we begin, in chapter 1, by reviewing the
core functions of central banking, and the global landscape of central
banks today.
In chapter 2 we describe the monetary policy challenge, and assess how
central banks have performed in recent years, especially in the context of
the credit crisis. Chapter 3 discusses the second main focus of activity,
in relation to financial stability, including a discussion of the appropriate
role for central banks in financial supervision.
Chapter 4 reviews the way central banks provide liquidity to the markets, which has changed radically in the credit crisis, their role as overseer of the payment system, and the part they play in government debt
management.
In chapter 5 we explore two of the more controversial questions that
have emerged as a result of the crisis: the extent to which central banks
should take account of the risks posed by asset price bubbles in setting
monetary policy, and the role they should play in determining capital
ratios for commercial banks.
Chapter 6 examines the structure, status, governance, and accountability of the major central banks today.
7

INTRODUCTION

Chapter 7 discusses the particular circumstances of the European Central Bank, and the further reforms needed to make the Eurosystem function effectively, while chapter 8 looks at the development of central banking in emerging markets, including the special case of Islamic finance.
Chapter 9 explores the efficiency of central banks and their costeffectiveness, a sadly neglected area. Chapter 10 assesses the way central banks cooperate internationally, and the role of the Bank for International Settlements. Chapter 11 reviews the culture and “psyche” of
central banks. What kinds of people run them? Has the “central banker
as hero” model gone too far? Is there an ideal profile for a governor?
Finally, chapter 12 pulls together the recommendations we make in
the earlier chapters and sets out an agenda for change.

8


chapter one

What Is Central Banking and Why Is It Important?

Societies become so used to the availability of stable currency, the ability
to make payments both domestically and internationally, and the existence of banks and other financial institutions through which to save
and borrow that it is easy to forget that each of these is a purely social
construct, fundamentally based on trust, albeit bolstered by legislation.
Occasionally, unpleasant reminders resurface abruptly that the financial
system is fundamentally fragile. It is rare, fortunately, that currencies
lose their value so fast that they cease to function—something that we
have recently seen in Zimbabwe and that happened in Germany in the
1930s—or that other payment mechanisms break down so that goods
and services can only be traded through barter. That tends to happen
only in wartime, as in Afghanistan in the recent past or, briefly, when
Iraq invaded Kuwait in 1991 and no one knew who controlled the Kuwaiti
central bank.
It is more common for individual banks or other financial firms to

fail. Banking is itself a fragile business because a bank depends on the
confidence of its depositors that it will be able to repay their deposits
whenever they want them, even though it has lent them out at longer
terms to borrowers. The maturity transformation that banks carry out
is in that sense a confidence trick.
All developed economic activity is dependent on this fragile financial
infrastructure, which requires its numerous constituent players to play
their parts as expected: the provider of currency must avoid issuing it
at such a pace that it is devalued; those making payments must deliver
them to the intended recipient ; savings should be made available to sustain investment and loans provided to sustain business activity, house
purchase, or consumer spending.
Society looks to central banks to try to prevent these inherent fragilities crystallizing or, if they do, to mitigate their repercussions. The
instruments at their disposal are quite limited and, in a sense, not very
9


CHAPTER O N E

sophisticated. Their main tool is their own balance sheet, as it is by
acquiring and selling assets and liabilities, borrowing and lending, that
they can seek to influence prices and interest rates in other markets. The
effectiveness of these actions is far from guaranteed—indeed the central
bank’s own balance sheet may well be constrained—and is dependent on
the wider economic climate in which they are operating. So the use of the
balance sheet has to be supplemented by suasion or guidance to the markets and to economic agents generally. Indeed it may be as much through
persuasion as through economic action that a central bank achieves its
aims. The combination of the two determines whether what the central
bank does makes any difference at all, given that its armory of tools
is essentially very limited. Changes in its balance sheet may be backed
up by an array of other controls, for which it may be responsible, on the

behavior of economic agents. These may be capital or exchange controls,
or controls on bank behavior, such as quantitative or price controls. But
in open markets such controls are of limited value in the long term.
Because the economic environment changes constantly, the way the
tools are used evolves. Political priorities change over time, sometimes
quite markedly and rapidly, with switches, even within a single country,
from ensuring credit is available to favored economic sectors to restraining inflation, and then, perhaps, to maintaining a particular exchange
rate.
Almost all countries now boast an institution called a central bank.
Central banking was not always so widespread, nor were its advantages
so widely acknowledged. In the United States, there were two unsuccessful attempts to establish a “central” bank, in both cases called the Bank
of the United States, before the Federal Reserve System was set up in
1913. There was a strong strand of thinking in the United States at the
time in favor of “free banking,” and a fully competitive banking system,
without the intermediation of a state-owned or state-backed institution
at its center. Indeed, arguments about the merits of free banking still
rumble on in some academic and political circles.1
Advocates of free banking argue that private monetary systems have
in the past been stable and successful, and that a competitive banking
system is less susceptible to bank runs, while the existence of central
banks has allowed political interference in the banking system, which
has had the effect of altering incentive structures and which has created
instability. These arguments have not, however, persuaded many governments. The balance of evidence appears to show that free banking leads,
instead, to systemic instability.2 So while arguments continue about the
10


WHAT IS CENTRAL BANKING AND WHY IS IT IMPORTANT?

sources of financial instability and, while even before the financial meltdown of 2007–9, the incidence of banking crises remained surprisingly

high,3 both the academic and the political debates now focus more on
the appropriate functions and responsibilities of the central bank rather
than on whether it should exist at all.
But what exactly do we mean by a central bank? The answer is not
straightforward. Indeed the definition of the functions that are appropriate for a central bank has changed considerably through time. As
the BIS Central Bank Governance Group points out, in the past central
banks “have been understood more in terms of their functions than their
objectives.”4
Historians of monetary institutions tend to date the introduction of
central banking to the foundation of the Swedish Riksbank in 1668 or to
the foundation of the Bank of England in 1694. But, as Capie et al. point
out, at that time there was no developed concept of central banking. The
Bank of England was founded as a private bank to finance a war. Not
until Henry Thornton wrote his An Enquiry into the Nature and Effects
of Paper Credit in the United Kingdom in 18025 was any theory of central banking as we would recognize it today articulated. Others argue
that the modern-day notion of central banking should be dated from the
1844 Act, which effectively gave the Bank of England a monopoly on the
issue of banknotes, or even from 1870 when the Bank first accepted the
function of lender of last resort. The other main European central banks
took on these responsibilities in the last decades of the nineteenth century. Nevertheless, Thornton’s enquiry into “paper credit” points to the
fact that central banks are seen to address the fundamental problem that
financial intermediation is based purely on trust documented in paper
or, now, in electronic form. If that trust breaks down, payments cannot
be made and savings become worthless. Recent events have provided a
very sharp reminder of that risk.
Many central banks, especially the oldest of them, began as privatesector companies; others started as public-sector agencies.6 The Bank
of England is in the former group; the Federal Reserve Board and the
European Central Bank are in the latter. The great majority are now
state owned, though partial private ownership persists in a few cases.
In principle, one can imagine an argument in favor of some private ownership, especially as a stimulus to efficiency, which, as we shall see, is

a neglected area. But as the allocation of profits is typically specified in
advance, even in partly private institutions, the case is weaker. Central
banks are clearly carrying out public objectives, in whole or in greater
11


CHAPTER O N E

part, so the case for state ownership is strong. Almost all of the 162 central banks now in existence are state owned. Private-ownership stakes,
where they persist, seem more an accident of history than a deliberate
policy objective. (In the United States a mixed model is in operation. The
Federal Reserve Board in Washington is state owned, while the regional
Federal Reserve Banks are statutory bodies that combine public and private elements, and which have boards selected largely from financial and
commercial firms in the district.) Private shareholding can entail risks,
too. “Rogue” shareholders may challenge a central bank’s actions, as has
happened in Belgium. Where the shares are quoted there can be inconsistency between stock exchange reporting requirements and policy-driven
restrictions on disclosure. There is no strong case, therefore, for retaining private ownership, and a clear trend toward nationalization. Even
governments with a strong ideological commitment to privatization have
not carried that enthusiasm into central banking. In some cases, though,
functions have been contracted out, or sold. The Bank of England, for
example, sold off its note-printing works a few years ago.
In terms of their formal responsibilities we can identify a gradual
expansion of the range of functions undertaken by central banks up to
the 1980s, and then something of an ebb in the last twenty-five years
in terms of the breadth of responsibilities, but certainly not in terms of
their overall status and influence. The latter part of the twentieth century was a golden age for central banks. While after the foundation of the
Swedish and English central banks at the end of the seventeenth century
there was a gap of more than 100 years before France established the
third central bank, 118 new institutions were established between 1950
and 2000. Every country with a seat at the United Nations wanted its

own central bank, and even some jurisdictions that might not normally
be regarded as independent countries, like San Marino, set one up. As
we shall see, these institutions gradually became more “independent,”
though independence carries a multitude of meanings in this context.
The growing complexity and diversity of the financial sector in most
parts of the world, and the rapid increase in government borrowing and
in capital movements, gave central banks more and more to do, whether
in the form of overseeing payment systems, undertaking basic banking
transactions for the government, handling foreign exchange flows, sometimes managing government borrowing, or supervising banks and other
financial institutions.
A significant boost to the number of central banks was given by the
collapse of the Soviet Union. Each former Soviet state established its own
12